When client informs an accountant that they wish to sell their interest in the partnership there begins the process of removing the original partners equity from the books and adding the new partner. Frequently senior accountants will use Section 754 step up adjustment to describe the generic reference for partnership base adjustment.    

Section 754 permits partnerships to make base adjustments however, section 754 is limited to such an authorization. 754 authorizes the partnership. Example, hen a 754 election is made, the partnership steps up the inside cost basis — but only for the new partner. This balances the inside cost basis and outside cost basis and reduces capital gains tax when a property that has appreciated is sold.

Consider the following scenario. Five partners contributed $100,000 each to purchase a property for $500,000. The property now has a market value of $1,000,000. Each partner’s inside cost basis is still $100,000, and their outside cost basis is still $100,000 each. Now, one of the partners sells their ownership interest for $200,000 and is taxed on the $100,000 gain.

Without making a 754 election, the asset’s inside cost basis would be transferred to the new partner with no adjustment. The new partner would have an inside cost basis of $100,000 and outside cost basis of $200,000. If the partnership decided to sell the property for $1,000,000, each partner would have a taxable gain of $100,000 — including the new partner. By making a 754 election at the time of ownership transfer, the new partner’s inside basis would be increased to $200,000. With an inside basis of $200,000, if the partnership decided to sell the property, the new partner wouldn’t experience a taxable event.